Friday, May 31, 2013

US inflation measures continue to decline. Government data showed that both the headline and the "core" PCE (excluding food and energy) indicators fell last month. Moreover, the core index hit the lowest level since this data has been collected, starting in 1960. And the core PCE inflation measure is the one most closely watched by the Fed.

Source: BEA

Some are pointing out that with this indicator at 1.05% there is a real risk of deflation. Whether that's true or not remains to be seen, but we want to keep in mind how dovish the FOMC has been recently.

As a reference, below is a simplified version of the Fed's economic "dashboard" that the Dallas Fed president Richard Fisher sometimes uses in his speeches (Fisher is hawkish but is not currently a voting member of the FOMC). A version of the PCE measure is the dial in the upper right of the "panel" below, pointing to the fact that the Fed deems anything below 1.5% as "yellow" and below 0.5% as "red". We are now about half way between these measures. With such perceived deflation risks in play, the relatively dovish FOMC is likely to press on with securities purchases for some time to come. With the core PCE at 1.05%, the Fed will be worried about the US becoming another Japan, stuck in a perpetual deflationary mode.

As discussed previously, economists maintain that in spite of the slowdown in manufacturing, the US consumer should provide the necessary lift to improve growth. According to the theory, with consumer confidence improving, the spending should follow. But that's not exactly what happened. While consumer spending is up on the previous year, the growth in spending has moderated to the lowest level in three years.

Source: US Department of Commerce

The explanation is simple: incomes are just not growing very fast (chart below).

Source: US Department of Commerce

The spike in personal income at the end of last year is "tax planning" - shifting of income into 2012 in anticipation of higher taxes in 2013 (taking capital gains, receiving special dividend income, receiving some of 2013 pay in 2012, etc.). Outside of that, income growth has moderated. These days "happy"consumers are not necessarily big spenders - the relationship between sentiment (which is at a six-year high) and personal spending growth is not solid.

Reuters: - "Consumer spending is on a very modest track because income is not growing very much. Wage gain is very low even though job growth has picked up," said Kevin Logan, chief U.S. economist at HSBC Securities in New York.

Many are still convinced that the consumer will "save the day" and push the US GDP growth higher this year. Perhaps. For now however we don't see much evidence to support that view.

As US banks continue to grow their deposit base, they are reducing reliance on commercial paper (CP). Why pay for funding when depositors are willing to provide capital for free and in increasingly larger amounts? On the other hand foreign-owned banks, a number of whom don't have a large retail presence in the US, have recently increased their issuance of CP. The chart below shows the divergence in CP outstanding between the two groups.

Thursday, May 30, 2013

The Arab Spring revolutions scored a number of political victories by removing several entrenched and ruthless dictators. The movement however failed to make economic strides, particularly in the lives of most ordinary people. In fact economic conditions in Egypt have deteriorated significantly since the revolution (see discussion). Many argue that these issues are temporary and will subside once political stability returns. Perhaps. For now however things are not looking great for the Arab Spring economies.

Take Tunisia for example. It had built a diverse, market based, export oriented economy, delivering a fairly consistent strong growth. The nation became an economic success across North Africa and the Middle East.

The CIA: - Tunisia's diverse, market-oriented economy has long been cited as a success story in Africa and the Middle East, but it faces an array of challenges during the country's ongoing political transition. Following an ill-fated experiment with socialist economic policies in the 1960s, Tunisia embarked on a successful strategy focused on bolstering exports, foreign investment, and tourism, all of which have become central to the country's economy. Key exports now include textiles and apparel, food products, petroleum products, chemicals, and phosphates, with about 80% of exports bound for Tunisia's main economic partner, the European Union. Tunisia's liberal strategy, coupled with investments in education and infrastructure, fueled decades of 4-5% annual GDP growth and improving living standards.

However, since the revolution, the Tunisian currency (the dinar) has been deteriorating, as capital continues to flow out of the country. The central bank has been trying to stem the decline (see article) with minimal success.

DNR/USD (dollars per one dinar)

That currency weakness (combined with other factors) is fueling inflation, which is becoming entrenched. Increases in food prices and rent are of particular concern.

Source: TradingEconomics.com

At the same time the GDP growth has fallen to 2.7% per year. With the unemployment rate of around 17% and inflation becoming a real problem, political instability is sure to follow. There is a good chance now that the parliamentary and presidential elections will be delayed, increasing the risk of more social unrest.

JPMorgan: - We believe parliamentary and presidential elections are unlikely to
be held before early 2014. In our view, discussions of the draft constitution
by the constituent assembly are likely to revive political tensions in coming
months. As an example, the opposition has fiercely criticized the draft
constitution while President Marzouki is set to face a no-confidence vote
before the constituent assembly. We believe the vote is unlikely to pass.
Yet, the political rift will continue to dominate the constituent assembly, in
our view, and to delay the formation of the independent commission to
oversee upcoming elections, which will likely delay the elections.

The nation's government budget deficit is also widening while foreign reserves have fallen sharply. As a result Moody's cut Tunisia's sovereign rating yesterday, with further downgrades possible.

Moody's: - The first factor underlying Moody's one-notch downgrade of Tunisia's government ratings to Ba2 is the country's persistent political uncertainty and the risk of instability. Although tensions have declined since the assassination of politician Chokri Belaid and the collapse of Prime Minister Hamadi Jebali's interim government in February, the risk of a further escalation in political instability remains high. ...

The second driver of the downgrade of Tunisia's sovereign rating is the fragile state of the Tunisian banking sector, particularly the large government-owned banks, which have severe asset quality issues and are largely undercapitalised. ...

The third driver of the downgrade is the significant external pressure on the balance of payments and government finances, as reflected by the decline in the country's official foreign-exchange reserves which cover the costs of only 95 days of imports (as of end of May).

Moody's has assigned a negative outlook to the rating to reflect the challenging political situation in Tunisia and the sizeable external pressures on the balance of payments and government finances. Any renewed period of political instability would likely have further negative consequences on the recovery of the economy, on fiscal metrics and also on the wider reform agenda in Tunisia.

In spite of all the excitement around Arab Spring, the movement so far has resulted in economic deterioration and growing risks to the stability across the region. Unfortunately, even a relatively prosperous and stable nation such as Tunisia has been unable to escape this fate.

Wednesday, May 29, 2013

The "seasonal" manufacturing activity slowdown in the US (discussed here) has arrived on schedule. It is visible not just in the Markit PMI measure (below), but across other national and regional indicators as well.

Here are some recent news quotes on the subject:

CSM: - The Federal Reserve said that U.S. factories cut back sharply on production in April, as automakers produced fewer cars and most other industries scaled back.

IBT: - A key index of U.S. manufacturing fell in April more than expected, the Institute for Supply Management said Wednesday. The ISM's purchasing managers index fell to 50.7 from March's 51.3, more that the 50.9 expected by analysts polled by Thomson/Reuters I/B/E/S.

MarketWatch: — Manufacturers in the Philadelphia region reported fewer orders for their products in May and became more skittish about hiring new workers, offering further evidence the economy is struggling to grow.

Investing.com: - Manufacturing activity in the State of New York fell unexpectedly last month, official data showed on Thursday. In a report, Federal Reserve Bank of New York said that Empire State manufacturing activity fell to a seasonally adjusted -1.4, from 3.1 in the preceding month.

But no worries. Why bother with manufacturing when US personal consumption remains firmly above 70% of the GDP.

The conventional wisdom goes that if the consumer is happy and in a spending mood, the US economy should grow. And given the ongoing rally in housing and stocks, American consumers seem quite happy indeed. Consumer sentiment hit a post-recession high this month (chart below). Now we just have to see if this happiness translates into sales.

Source: Econoday

Given these improvements in consumer sentiment, nobody seems to care much about the silly manufacturing slowdown. The consensus seems to be that the US consumer will come to the rescue once again.

France continues to pose the biggest near-term risk to the euro area's economic recovery. Why France some may ask? After all it was Italy and Spain who presented the biggest challenge to the union's stability in 2011 and 2012. The situation in those two nations is dire indeed. However the so-called "hard" economic measures in Italy and Spain have generally "caught up" with the "soft" indicators (surveys). For example the Italian GDP growth is now roughly in sync with the service PMI measure (below).

Source: Markit

Spain's hard indicators may have even "overshot" the "soft" ones to the downside. Spain's and Italy's recession is effectively "priced in" - i.e. reflected in the hard measures such as the GDP or the industrial production. Furthermore, there are signs of the periphery nations' contraction bottoming out (see discussion). France however is a different story. The nation still shows a relatively small GDP contraction, while survey indicators look horrible (chart below).

That gap creates a risk that France is yet to undergo its deep "official" recession, which would hold back the Eurozone as a whole. And France's "soft" measures of output continue to lag the rest of the Eurozone (see discussion). What's particularly troubling is that France's "soft" economic indicators show a broad deterioration - in both business as well as consumer sentiment.

Business sentiment:

Consumer sentiment (record low for France):

Given that France is over a fifth of the area's GDP output (see chart below), there is a clear risk that if the nation's "hard" indicators catch up with the "soft" ones, the Eurozone's recovery may take considerably longer.

Tuesday, May 28, 2013

Facing concerns about dwindling oil production capacity (ability to supply incremental amounts of crude into the market) Iran responded back in April with a statement that the nation has plenty of spare capacity and is simply dealing with weak global demand.

FARS: - "The current capacity of Iran's crude oil production is 4.2 mb/d and we are currently supplying oil as much as the world market needs," [Iranian Oil Ministry Spokesman Alireza Nikzad Rahbar] said.

According to Iranian officials the demand weakness in global crude markets is mostly due to slowing economic growth in the US - driven by US budget cuts.

FARS: - According to Khatibi, following the failure in solving budget issues, the US administration has decided to reduce its expenditures, which in turn can have an impact on
economic growth and oil demand by the country.

... "These days those negative factors including slowdown in oil demand growth and worsening economic outlook in industrial countries especially the US are prevailing in the market," he added.

The statement basically says that Iran can provide all the extra crude the world needs, and would have produced more if it wasn't for the faltering US economy. But all this wonderful rhetoric aside, does Iran really have the capacity to produce 4.2 million barrels of oil per day (mb/d)? According to JPMorgan, the nation's current capacity is actually closer to 3.3 mb/d. Moreover, the capacity is expected to continue its decline.

Source: JPMorgan

The sanctions have curtailed Iran's ability to apply some of the more modern techniques to improve oil field capacity. The nation's industry continues to rely on re-injecting natural gas back into the huge but aging fields to maintain pressure. Over time this traditional extraction technique will result in falling yields.

In spite of Iran's problems, OPEC's capacity is expected to continue to rise. Nations such as Iraq will more than compensate for Iran's dwindling capacity (chart below). In the end Iran is becoming increasingly marginalized as an oil producer, both within OPEC and outside - particularly as North American production ramps up. And unfortunately in this increasingly competitive energy supplier environment, it will be Iran's ordinary people who will feel the brunt of the nation's capacity constraints.

One of the leading indicators analysts often look to in order to understand economic trends is the air cargo volume. For example, according to Reuters, Singapore's Changi Airport "moved 1.8 percent less cargo in April from a year ago". That's a potential indication of weakness in demand not just in Singapore, but across Asia's other economies.

The health of the air cargo industry is also plagued by another (related) factor: overcapacity. Singapore Air for example just announced it is mothballing its second cargo plane since December of last year.

This combination of global economic weakness and overcapacity has resulted in a sharp decline in ISI's air cargo industry survey. And unless Apple comes out with another high-demand product, things don't look good for the industry. This may also be a signal that the relative weakness across some of Asia's major economies is worse than many had assumed (we may already be seeing signs of that in China's latest PMI numbers) .

Sunday, May 26, 2013

Here is a quick followup to an earlier post on pushing the elevator button more than once. It will not make the elevator come any sooner.

The Fed's securities purchases have sharply increased banks' excess reserves, while credit expansion continues roughly on its original path. That's because excess reserves have already been elevated prior to the start of QE3 (the elevator button has already been pushed). The banking system has effectively been saturated with liquidity, and massive incremental liquidity adds little additional incentive or ability for banks to extend credit.

A number of economists are trying to read into the meaning of Bernanke's statement last week. The comment that put a damper on the relentless equities rally and sent prices of treasuries lower. In particular the comment "we could take a step down in our pace of purchases" at the next FOMC meeting is causing angst in the investor community (see post).

But what would such "tapering" in monetary expansion look like? The most likely outcome is a shift from $85 billion of purchases a month to something closer to $60 billion. Here is the impact such a policy would have on the central bank's portfolio of securities.

The Fed is unlikely to do anything more dramatic, given the central bank has bet its reputation on this program. Reducing monetary expansion sharply just to return to it later will clearly be problematic. The outright holdings will therefore comfortably go above $3.5 trillion by the end of the year in spite of this policy pace "step down".

Friday, May 24, 2013

US gasoline prices have been on the rise, as peak diving season approaches while a number of refineries have been undergoing scheduled and unscheduled maintenance. The price increases have been particularly acute in the Midwest.

Midwest has fallen steadily since the start of 2013, and is now about 83 percent of capacity, below the U.S. average of 87 percent. As of May 17, Midwestern gross refinery inputs were averaging 279,000 barrels per day (bbl/d) lower than at the start of the year. The reduction in runs reflects a combination of routine seasonal turnaround and maintenance activity, unplanned outages, and longer-term upgrading initiatives

But it seems that in spite of these constraints, price increases - at least at the national level - have stopped.

Source: Gasbuddy.com

This is the result of a recent surprisingly sharp increase in the national gasoline stocks, with supplies now running above the 5-year range for this time of the year. And that should provide some relief for Memorial Day drivers as prices stabilize or even decline.

This may be an unpopular suggestion, but those with a contrarian view of the world will surely appreciate the logic here. The chart below from Goldman shows the consensus economic forecast for 2013 GDP growth of the large Eurozone nations. Again, this is not the actual GDP, but a forecast over time.

Source: GS

It shows that the "herd" of forecasters following each other in the realization of how dire the recession has been across the area. But keep in mind that these are some of the same forecasters that 18 months ago were calling for a "shallow" downturn in these nations (see discussion).
Many weren't even talking about a possible recession. And now they are continually downgrading their predictions - after the fact?

Today we got the latest PMI numbers from the Eurozone. France is clearly struggling and Germany's growth has been slower than many had hoped - due primarily to global economic weakness. But take a look at the rest of the Eurozone. While still in contraction mode, it shows an improving trend.

Spain printed a trade surplus last month (surprising some commentators), which may be a signal to rethink how valid some of these forecasts really are. Nobody is suggesting we will see Spain or Portugal all of a sudden begin to grow at 5%. But given the extremely pessimistic sentiment of many economists (a contrarian indicator), it is highly possible we are at or near the bottom of the cycle. People should not be surprised if we start seeing some positive growth indicators - especially in the periphery nations - in the next few quarters.

Thursday, May 23, 2013

Equity investors might find it a bit surprising that the rating agencies are not necessarily all that excited about the recent wave of stock investor activism. In fact some view such aggressive investor involvement as risk to corporate credit. Instituting strong corporate governance is certainly a positive, but equity investors will also continue to insist that companies do something with their cash (see discussion), including paying dividends or buying back shares. That ends up helping shareholders in the short run but increases net leverage - which is not ideal for credit investors. And certain structural, management, and board changes that result from shareholder activism will conflict with the needs of corporate debt holders.

Fitch: - The unprecedented level of shareholder activism seen across the energy space has increased the tail risk of future unexpected shareholder-friendly actions for credit in the space, according to Fitch Ratings.

Activist campaigns and/or proxy-related issues have flared up widely across the energy sector this year at several key names including Hess, Nabors, Transocean, Chesapeake, and Occidental Petroleum. The net result of these campaigns has been a wave of changes on the corporate governance, financial, and operational levels.

... Financial changes such as new shareholder-friendly distributions include new or expanded buyback programs and new or expanded dividend payouts while operational changes include accelerated restructuring plans and asset sales.

Wednesday, May 22, 2013

It took one sentence to send shockwaves through the financial markets.

Bernanke: - We’re trying to make an assessment of whether or not we have seen real and sustainable progress in the labor market outlook. If we see continued improvement and we have confidence that that is going to be sustained, then we could in -- in the next few meetings -- we could take a step down in our pace of purchases.

US equity and fixed income markets declined sharply in response. To understand just how much asset prices depend on this stimulus from the Fed, consider the move across the treasury curve today. The increase in the 10yr yield was larger than in the 30yr. The Fed does not hold much in the long bond type durations relative to those that are 10yr and shorter. The long bond is therefore not as exposed to the Fed slowing its purchases as the 7-10yr notes.

The central bank's balance sheet - not the fundamentals - has been driving bond pricing and is the key determinant of the treasury curve's shape. Today was just a hint of how the eventual exit from QE may ultimately play out. This does not bode well for other asset classes (such as high-dividend shares which sold off sharply) whose valuations have become dependent on this stimulus rather on fundamentals.

As predicted back in October (see discussion), dollar LIBOR is now being priced (roughly) off certificate of deposit (CD) rates. Imagine being a bank's treasurer responsible for submitting LIBOR quotes to the BBA. If you can't justify how you obtained your rate and someone accuses you of LIBOR manipulation (see post), it could cost you your job and more. The sources of LIBOR rates were supposed to be quotes on interbank loans. But unsecured interbank lending volumes have been suppressed since the financial crisis. In fact current levels are similar to what they were in the 80s (see chart below). And most of the activity is in the overnight markets with very little transacted at maturities of one month or greater. (Note: some confuse the sources of LIBOR rates, such as interbank lending, with products that price using LIBOR rates, such as interest rate swaps. Here we are discussing the sources.)

With little to go by in the way of actual quotes, setting these rates becomes a real headache for banks. By pricing LIBOR off something that's highly transparent, like CD rates, makes the quotes easier to justify. After all, a CD rate is where a bank is willing to borrow money for a fixed term - which is what LIBOR is supposed to be. That's why LIBOR has been fixed at a fairly constant average spread to CD rates. The 3-month LIBOR is now roughly 7 basis points above the 3-month CD rate (note that the CD average here includes retail quotes - larger term deposits yield more and the spread of those large CDs to LIBOR is even tighter).

Ironically CD volumes are declining as well (see discussion). But as long as banks continue to openly quote the full CD term structure (across different maturities), banks will use the CD curve as a guide to set LIBOR rates.

Tuesday, May 21, 2013

On its risk appetite index, Credit Suisse views the index value of 5 as "euphoria". And we are headed there, as markets embrace risk.

Source: Credit Suisse

This is not surprising given where credit markets are trading. As an example, the Merrill European High Yield Index average yield is now below 4.5% (4.46% to be precise). Keep in mind this is sub-investment grade debt mostly from European issuers. The yield on these bonds is now less than half what it was just a year ago.

Sunday, May 19, 2013

Corporate treasurers' risk tolerance remains low as they prefer to hold record amounts of cash on their balance sheets.

Source: JPMorgan

This is taking place at the time when companies have issued record amounts of debt to take advantage of ridiculously low rates. Increasingly however the proceeds of those bond sales and other borrowings sit in cash. The difference between total and net debt in the chart below is cash (above).

Source: JPMorgan

Markets are betting that some of this cash will ultimately turn into stock buybacks or dividends. Shareholders are certainly demanding it. Over time that will leave some of these firms more leveraged, and unless they "grow into" this debt, more vulnerable to downturns.

Japan's monetary experiment is truly unprecedented, both in size and scope. Not only is the overall central bank balance sheet growth accelerating, but the assets purchased are not just government securities.

Total Assets (source: BOJ)

The Bank of Japan is buying up REITs and stock ETFs to prop up both asset classes. The amounts are still relatively small, but the buildup is quite rapid.

BOJ's holdings of ETFs

BOJ's holdings of REITs

And with Keynesian economists cheering the BOJ on (see post), the policy is rapidly achieving the desired result. Japanese authorities are ecstatic - dollar-yen just broke 103 as the yen "printing presses" quickly debase the currency. Japan will quickly have a competitive advantage over South Korea, Germany, and in some cases even China. Japan's exporters are popping the Champagne corks ...

Yen per one dollar; source: Investing.com

The nation's stock market is now up over 75% over the past year as investors celebrate the massive stimulus, BOJ's direct purchases of ETS and REITs, and a rapidly depreciating yen.

Goldman: - Strong Q1 growth, technical upward revision to our FY2013 forecast
Jan-Mar real GDP growth came in at +3.5% qoq annualized, substantially outpacing the market consensus forecast of +2.7%. Consumption was the driver rising +3.7%, while exports turned positive for the first time in four quarters.

We raise our FY2013 real GDP forecast to 2.8% growth, from 2.5%, based on the strong GDP numbers for Jan-Mar.

The Bank of Japan's biggest achievement of course is pulling the nation out of the prolonged deflationary spiral. Market-implied inflation expectations have risen sharply over the past year, quickly approaching those in the United States.

5y inflation expectations (source: JPMorgan)

This is a great lesson for central banks around the world. If much needed structural changes fail or competitive pressures become too great, let you central bank resolve the situation. Just as the ECB "saved" the EMU with its OMT bond backstop policy, Japan is showing that highly aggressive central bank actions can work beautifully in the short term. But what happens in the long run some may ask? Don't worry about that, because as Keynes famously pointed out, "... this long run is a misleading guide to current affairs. In the long run we are all dead."

A quote from an elevator mechanic in NYC: "You need to push the 'up' button to make the elevator come up. But pushing the button many times is not going to make the elevator move any faster."

We continue to receive emails pointing to what some have called "a broken monetary transmission" in the US. On the surface the argument looks compelling. The Fed's securities purchase program is expanding the monetary base - the amount of dollars in the system. In theory some of those extra dollars should encourage the banking system to extend more credit than it normally would, ultimately growing the broad money supply (M2 for example). But that's not how things turned out.

Unit = $ Billion

The argument goes that the banking system is broken and is unable to grow credit - which is being manifested as tepid growth in the broad money stock. Is that what's really going on here?

A closer look reveals that the slow growth in M2 is driven primarily by the leveling off in the amount of deposits in the US banking system (in the chart below the monthly fluctuations reflect the payroll cycle). Note that the spike at the end of last year is the "income harvesting" prior to higher tax expectations (see post).

Deposits in the US banking system (NSA, source: FRB)

But is this leveling off in deposits that unusual? How does it compare to changes in total deposit balances across US banks over longer periods? It turns out that the growth of deposits in the United States has actually been fairly steady - roughly 6.8% per year over the long run. The chart below shows a fit to 40 years of weekly deposit data.

While deposit growth fluctuated over time, it has maintained a steady growth trajectory. Recessions, market booms, Fed's policy, reserve requirements, etc. have had a relatively minor impact on deposit expansion in the long run. And based on this fit, we are currently right about where we should be in terms of the overall deposit levels.

The assumption that the banking system can generate unlimited amounts of broad money simply because the banks have been injected with record levels of reserves is wrong. Banks' capacity to grow credit has always been limited, and it's no different this time. The "monetary transmission" is not broken - it is simply constrained.

The recent fluctuations are due to flows into stocks, mutual funds, short-term income funds (see post), etc. Deposits in the system will continue to grow at roughly 6.8% a year as they have done for the past 40 years, possibly longer. Therefore the broad money supply - a great deal of which are deposits - will never keep up with recent unprecedented growth in the monetary base (which is up 18% YoY). The elevator "isn't going to move any faster".

Friday, May 17, 2013

Emerging economies have always run higher inflation rates than developed markets (DM) due to stronger growth. The spread in inflation rates has generally been steady, running roughly 2-3 percentage points. Recently however the spread has blown out to over 4% - a post-recession high.

Emerging nations selling into developed markets are losing pricing power and will have a tougher time keeping up with domestic labor cost increases (some of which are forced by their governments). EM corporate margins are already under pressure, ultimately weakening growth. India or Mexico are good examples (charts below). While temporary, this divergence could be quite disruptive in the near-term.

Thursday, May 16, 2013

According to Nick Timiraos from the WSJ, the latest drop in the seasonally adjusted housing starts measure is nothing to worry about.

In fact he lists 4 reasons why this unexpected decline isn't in any way a sign of potential slowdown in the housing market.

WSJ: - Thursday’s housing report isn’t as much a signal that the sector is cooling—at least not until there are a few more of these reports—and instead a sign that the housing rebound isn’t going to unfold in a straight line

Perhaps. If we are not witnessing a cooling in new home construction, maybe Mr. Timiraos can explain why lumber futures have declined over 20% in the last couple of months. In April the explanation for the decline was related to cooler than usual weather conditions hampering construction. What happened in May? Some have rationalized this by the economic weakness in China. But the last time we checked a large chunk of this Globex-settled lumber still goes into new home construction - while the supply certainly hasn't changed. We look forward to hearing Mr. Timiraos' explanation.